Hard line on Cyprus signals rising sovereign risk fears

By:
Peter Lee
Published on:

Senior board member of a eurozone bank, and advisor to troika, reveals the EU's brutal Realpolitik in Cyprus bailout as sovereign debt fears re-emerge.

Euromoney speaks to a senior board member of a eurozone bank who provided some advice to the troika negotiators on Cyprus that this was a good time to bail in the debt of lenders to banks in a country with no great systemic relevance and a broken economic business model. He believes the final outcome was a good one, even though the path to it was tortuous and the result will be a rise in his own banks’ cost of funding.

He says: “It’s extremely important that insured depositors were preserved. Large depositors may get haircut by 25% to 40% but shed no tears for the hot money that got burned in Cyprus. Small depositors will not suddenly pull their money from banks in Greece and Spain and take it to Paris or Frankfurt.”

He concedes: “Dijsselbloem’s comments were extremely unhelpful and he will be wrapped on the knuckles because that does not reflect anyone else’s thinking in Europe. This does not presage further bad news for depositors. But it certainly tells holders of bank bonds that they may be at risk.”

Here’s the kicker. Why was it so important now to take such a hard line on bail-in with a non-systemic country? “Because you cannot keep going back to the well of the German taxpayer when we may still need to do so for Spain and even for France.”

It’s a comment that shows how deep worries run of a renewed break out of sovereign stress in the eurozone. Investors’ concerns are rising.

Luca Paolini, chief strategist at Pictet Asset Management, says: “The botched bailout of Cyprus, the political deadlock in Italy and the country’s subsequent credit rating downgrade by Fitch to BBB+ serve to remind investors that the eurozone debt crisis remains unresolved.

“Cyprus shows how a small problem can easily morph into a crisis if not properly managed. The country’s banking troubles might well be a special case – bank deposits are almost four times the country’s GDP and are mostly held by foreigners.

“Yet the bail-in of depositors [above the €100,000 limit] and senior bondholders, as well as the introduction of capital controls, sets a dangerous precedent and will in all likelihood encourage deposit outflows from other heavily indebted EU countries at the very first whiff of trouble.”

He does not share the banker’s optimistic view of the outcome for Cyprus. “Our view is that the bail-in of depositors in Cyprus cannot be simply dismissed as a containable, local problem – it could potentially be a watershed event, undermining ECB president Mario Draghi’s pledge last year to do ‘whatever it takes’ to save the euro.

“The handling and terms of the Cyprus bailout threaten to undermine long-term confidence and trust in European institutions at precisely the wrong time. At a minimum, it represents a policy mistake, one that EU officials may come to regret should the eurozone crisis take another turn for the worse – a scenario we view as highly probable.”

Only time will tell if the hard line on Cyprus is an indicator of eurozone policymakers bracing for severe sovereign risk strains to re-emerge soon, not just in the periphery but even the soft-core of Europe.

At the start of the year, US credit hedge funds chasing yield were big buyers of peripheral government bonds. Asian money flowed into French and Belgium government bonds on the basis this was Germany with a spread. Will they live to regret doing so?

It might be that the banker advising the troika is overly pessimistic on deteriorating credit fundamentals in France: equally it’s hard to share his optimism on the read across to European banks.

Olly Burrows, banks credit analyst at Rabobank, notes: “Arguably, bail-in is a political instigation, which is thus nigh on impossible to predict, and certainly hard to price. Looking around Europe at some of the weaker banks, or banks in weaker countries, this very real risk of bail-in should raise the cost of credit considerably.

“Can anyone say with confidence that further troubles in an already weak bank, or in a difficult economy, would not be treated in the same way? When banking union is in operation, all European banks will have to be dealt with in a similar manner.

“Cyprus may be unique, but bail-in of Laiki is not. It is merely the first. Investors need to accept that, and ensure that they have priced for this risk accordingly.”